Financial Ratios & Wealth Building

Learn how you “CAN” use financial ratios to build wealth by taking Conscious Action Now…

In this discussion TheWealthIncreaser.comwill look at a myriad of financial ratios that can lead you closer to the success that you desire. With 2017 coming to an end and a new year only days away, it is the desire of TheWealthIncreaser.comthat this page will serve as an inspiration for you to do more in 2018. OK, here we go–hopefully TheWealthIncreaser.comwon’t bore you too much and you can use the following paragraphs to achieve more in 2018 and beyond!

Rule of 72 Ratio:

Dollar Amount Invested/ Interest Rate

1,000 / 7% = 14.3 or just over 14 years to turn $1,000 into $2,000

1,000 / 14% = 7.1 or just over 7 years to turn $1,000 into $2,000

Relevance:

The ‘Rule of 72‘ is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors (you) can get a rough estimate of how many years it will take for the initial investment to duplicate itself or double.

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If you were invested in the stock market over the past several years and you had a total stock market investment you could have possibly doubled your money in the past 5 years (1000/.20 = 5.0 or exactly 5 years), or if you had a million dollars to play with after all of your living expenses and retirement goals were set in place you could have turned that million dollars into two million dollars with virtually no effort on your part other than having the ability (and willingness) to do so–and not suffering much in case the market went the other way (and you were to suffer losses) due to you knowing your risk tolerance level up-front as well as the goals that you had in place.

Liquidity Ratio:

Liquid Assets / Total Assets

30,000 / 140,000 = .2142 or 21%

Relevance:

Lets you know what percentage of your assets are liquid (cash, certificates of deposits, money market etc versus stocks, bonds, mutual funds, home equity etc.) so that you can plan your lifestyle accordingly.

To further drive it home, if you had a $5,000 credit limit and held a $2,000 balance, your credit ratio would look like this for one creditor:

2,000 ÷ 5,000 = .4, or 40%

If you had a $25,000 credit limit with all of your credit cards and monthly installment payments and held a $12,000 balance, your credit ratio would look like this for all of your creditors:

12,000 ÷ 25,000 = .48 or 48%

Relevance: The lower your credit ratio the better as lenders use the credit ratio to grant you more credit or provide you credit at the best rates based in large part on how you use credit and your payment history. See the chart below to determine your current risk level!

Credit Ratio Risk < 30% Low (ideal)
30-49% Medium
50-75% High
76% or more Very High

The types of credit available include: Revolving Credit, Installment Loans and Open Credit.

Finance Company Accounts and Mortgage Loans will fall in the above categories, however realize that some lenders categorize them separately as well.

Debt to Income Ratio:

Total Debt / Total Income

Also called Front End Ratio

Let’s say you have $10,000 in Gross Monthly Income (your income before any taxes or other deductions are taken out – your actual paycheck will likely be much less).

What can you afford as far as your home purchase is concerned?

x / 10,000 = .28

2.800 / 10,000 = .28 which is the maximum debt you could have on the front end (excludes housing payment)

X = 2,800 max on front end

You may not be approved for a mortgage loan in which the PITI payment exceeds $800 per month if you maxed out your front end ratio of 28 percent. On the flip side, if you had zero outstanding balance you could possibly qualify for a loan up to $3,600 per month!

On the back end your maximum debt would be $3,600 calculated as follows:

x / 10,000

3,600 / 10,000 = .36 which is the maximum debt you could have on the back end (includes housing payment)

If you maxed out your credit on the front end (bills totaling $2,800 per month) you would only have $800 available for housing payment (includes principal, interest, taxes and insurance or PITI). If you had bills greater than 10 months averaging $400 per month you would qualify for a loan up to $3,200 per month.

What that means in purchasing power or how much home you can afford based on this ratio depends on the current interest rates, the local property tax rate, the amount of your down payment, mortgage insurance, and homeowners insurance. In other words, how you manage your finances and your particular market are the key factors that can lead to you purchasing the home of your dream.

The amount that you will be approved for will vary over time and across different locations as the market interest and where you are will play a factor. However, always realize that high debt on the front end will bring down the amount of house you can afford based on the conventional ratio breakdown of 28% on the front end and 36% on the back end.

To further drive it home let’s look at another example, monthly debt in excess of one year divided by gross monthly income is your debt to income ratio or front end ratio! If you earned 3,600 per month and had credit card and car payment totaling $800 your front end ratio would look like the following:

800/3,600 = .22.22 or 22% on the front end for conventional–good

1,300 / 3,600 = .36 or 36% which only leaves $500 per month available for housing payment on the back end for conventional–probably not enough for quality housing in most markets

Relevance:

The front end and back end ratios provides you the ratio that you need to determine the level of debt that you are carrying in relationship to your monthly income. You don’t want to overextend yourself with debt and make life more difficult and painful while here on earth. You must know how to manage your credit wisely and pay your debt in a timely manner.

You also don’t want to put yourself in position where you are house and/or car rich and cash poor–your life will be a bore! Use these very telling and powerful ratios to make life as enjoyable as possible for you and your family while you are here on planet earth.

Housingand Debt to Income ratio:

Also called the back end ratio

Monthly debt in excess of one year plus expected housing payment (PITI) divided by gross monthly income, for example

1,200/3,600 = .33 or 33%

To further drive it home, the back end ratio is the total debt to income ratio, which includes your housing debt AND other debtowed for at least the next 10 months or so, by you the borrower.

Back End Ratios may not exceed 36% in most cases.

Some Qualified Mortgages (FHA) may let the Back End Ratio be as high as 43%.

If you the buyer have $1,000 worth of other debt and monthly income of $4,800 (car loan, student loan, credit card, etc.), how much can you afford?

1,000 / 4,800 = 21.7%–Good on the front end ratio for conventional

2,000 / 4,800 = 41.6%–Not good on the back end for conventional but some lenders could possibly still make it happen for you

As far as FHA goes, you would qualify with both the front end ratio 31% and the back end ratio 43% because both of your ratios are lower than those percentages (21.7% and 41.6% respectively).

When your other debt is taken into consideration, you the buyer(s) can afford a home with a PITI payment of $1,000 using and FHA loan and you would not qualify for a conventional loan according to the financial ratio guidelines. However, you could possibly qualify for a conventional loan even with those ratios if a conventional lender worked with you to make it happen.

If you are like most buyers, going up to a 36% debt to income ratio is not comfortable!

A 43% back end ratio is even more difficult to handle, even for the most frugal purchaser(s).

However, a better school district and/or being closer to your job or family members may well be worth the trade off! It all depends on what you value and your ability and willingness to put into place a process that allows you to know your cash flow position up frontso that you can better plan for your living conditions in the future.

Do you have an adequate emergency fund and have you planned for your future in a comprehensive way? By answering these questions you can get on a path toward making the best decision for you and your family.

If you like to eat out, entertain and save abundantly for your future you might determine that a 43% ratio is too high a price to pay at this time and you might postpone your home purchase until you could get more income coming in on a monthly basis or you paid off certain debt. Your lifestyle and plans for your future will play A LARGE PART IN DETERMINING THE BEST APPROACH TO TAKE.

The temptation may be great and you may want to go for a 43% back end ratio. What would that look like with our current example?

You still would only qualify for a loan of $1,060 (2,160/4,800) unless FHA decided to allow you to go higher or you paid off some debt or increased your monthly income.

NOTE: When you decide to purchase your home where you will seek a loan, remember that Lenders will pull your credit reports and ask for 2-3 months of your past bank statements.

If there is a sudden, large amount of money added to any of your bank accounts, or if your credit card balances or car loan are paid off just prior to applying for a loan, this sends up a red flag and some lenders will be hesitant to offer you a loan without a reasonable explanation of why you took those actions.

Lenders may ask for a gift letter, indicating that the money does not have to be paid back, and may request a larger down payment, such as 10% instead of 3.5% or 5%.

It is wise for any buyer to get their financial accounts in shape “well before” applying for a mortgage loan so that they will not be disappointed!

The critical back end ratioshows your ability to take on more debt (your new housing payment).

Mortgage lenders generally will not lend more than what would constitute 28% of a person’s monthly gross income before adding their monthly home payment to the back end.

If there is other debt, mortgage lenders will generally not originate a loan that causes a borrower’s total debt to income ratio to exceed 36% (mortgage plus other debt).

Conventional 28% front end and 36% back end, or

FHA 31% front end and 43% back end

Certain circumstances allow lenders to go higher…

Sales Price to List Price Ratio:

Sales price of a home divided by what the property listed for, for example

290,000 / 310,000 = .9355 or 94%

Relevance:

By calculating the ratio of sales price to list price of recent sales in your target market (the area where you plan on buying your home or listing your home for sale) you can get a better feel of what you should offer as purchase price, or if you are selling—the listing price:

Is it 90%? 95%? 103%?

By knowing that ratio you put yourself in position for a more realistic purchase price offer or sales price listing.

Loan to Value Ratio:

Loan amount / purchase price or refinance value

For example,

288,000 / 360,000 = .80 or 80%

You may also see CLTV or combined loan to valuewhich simply means all of your outstanding loans (2nd mortgage, home equity loan etc.) divided by purchase price or refinance value

Relevance:

By knowing your loan to value ratio you understand immediately how much debt you are taking on from a percentage standpoint. When you get to a certain equity position you may also be able to eliminate PMI or MIPfrom your monthly housing payment so it is important to know this number.

The following ratios are used to Value Real Estate & the Relative Value Depends on Your Particular Market, therefore what is acceptable in one area may not be acceptable in another area, use with caution in mind.

Capitalization Rate Ratio:

Net Operating Income (from Schedule E or elsewhere) / Purchase Cost

30,000 / 390,000 = 7.7%

Limitation: does not take into account financing

Cash on Cash Ratio:

Cash Flow before Tax / Cash Invested

6,000 / 85,000 = 7.1%

Is the strongest Method, it does take into account income, expenses and financing

Price per Square Foot Ratio:

Cost / Number of Square Feet = price per square feet

300,000 / 3,000 = $100 per square feet

Limitation: does not take into account income, expenses and financing

Price per Unit Ratio:

Cost / Number of Units = price per unit

300,000 / 4 unit quadplex = $75,000 per unit

Limitation: does not take into account income, expenses andfinancing

Gross Multiplier Ratio:

Cost / Gross Operating Income

300,000 / 50,000 = 6%

Limitation: does not take into account expenses and financing

NOTE:the above numbers are rounded for illustrative purposes

Relevance:

For those who invest in rental property it is imperative that they understand the amount of CASH FLOWthat they will receive (be sure to look at schedule E of the seller(s) tax return prior to purchase), they estimate the APPRECIATION that is expected or projected, they know the amount of PRINCIPAL REDUCTIONthat is expected at various intervals of the loan and they know the amount of DEPRECIATION (and how to break down the various elements of depreciation for their greatest benefit). Always remember that you cannot depreciate land on rental properties.

By properly analyzing the rental property that you plan on purchasing and utilizing the appropriate ratios you CAN get a better appreciation (no pun intended) of the returns that you will or potentially can achieve based off of your purchase.

You can then know in the future if selling your property, refinancing your property, continuing to hold your property or doing a 1031 exchange will serve your best interest. You also want to have an awareness of the tax implications at the time of purchase or preferably before you purchase so that you will have no future surprises.

Will you be taxed at ordinary income or capital gain rates? What is your basis and what will you pay taxes on after depreciation. You must understand that depreciation recapture will occur whether you take the depreciation—or you fail to do so. Will you plan to avoid taxes in the future or will you just jump into your real estate investing career with no real plan of action as it relates to your tax implications that you will face at the time of your purchase, yearly and when and if you sell in the future?

Do you know about form 3115and how you could possibly amend your tax returnto get the depreciation that you overlooked if you currently own investment property and you failed to claim the depreciation? By claiming the depreciation that you were entitled to you in essence put cash back in your pocket in a real way! These are just some of the more pressing questions that you must ask–and answer on the front end if you are to maximize your rental property purchase.

Even if you purchase and quick turn properties for short term gains, you must realize that there will be tax implications (ordinary income rates if sold in less than a year and capital gain rates if sold after a year). Whether you quick turn for a profit or buy and hold for cash flow and appreciation you must consider the combined tax implications at the federal as well as at the state level.

CONCLUSION

It is important that you use financial ratios (where and when appropriate) so that you can maximize your returns and minimize your mistakes during your lifetime. By utilizing the above ratios among others–you can put yourself and your family on a positive pathtoward building wealth.